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Sustainable returns: The strategy, launched on May 1, 2013, aims to capitalise on the idea that companies will generate better long-term stock returns if they mitigate environmental, social and governance (ESG) risks. Our analysis indicates that governance risk influenced stock performance more than other sustainability factors from the end of 2010 to March 28.

Higher tracking error: The strategy combines our existing investment process, which uses statistical evidence to identify market inefficiencies, with new and proprietary ratings of companies’ ESG risk exposures. By targeting a tracking error of 4-6% and investing in between 80-100 companies worldwide, we are taking more stock-specific risk than in our global equity strategy, which maintains a tracking error of 2-4%. We expect an excess return of 3-5% each year in the new strategy versus its benchmark, the MSCI All Country World Index.

Quantifying ESG risk: Our Q-ESG Score ranks each company’s sustainability practices against their sector peers. Developed as part of the revamped ESG Dashboard, a risk management tool used by equity and credit teams at Hermes Fund Managers, it draws on proprietary and external research to rate more than 3000 companies.

Proprietary insight: To generate the scores, we use research from Hermes Equity Ownership Services (Hermes EOS) – which represents about $150 billion of institutional investor assets– and data feeds from Sustainalytics, Trucost, FactSet and Bloomberg. We do not rigidly exclude stocks: companies that are improving the ways that they mitigate sustainability risks, and those in constructive dialogue with Hermes EOS, will be considered for investment.

Governance gains: Among ESG risks, governance was recently the strongest contributor to returns. It drove a 40-basis-point divergence each month between the best and worst-performing stocks, known as the quintile spread, between December 31, 2010 and March 28, 2013.

Quintile spread of the Q-ESG scores categories (%)

Note: The chart above shows the quintile spread, the performance differential between the stocks ranked most attractive and least attractive on each factor.